360 Capital Group Limited (ASX:TGP) outperformed the Office REITs industry on the basis of its ROE – producing a higher 30.59% relative to the peer average of 15.57% over the past 12 months. On the surface, this looks fantastic since we know that TGP has made large profits from little equity capital; however, ROE doesn’t tell us if management have borrowed heavily to make this happen. Today, we’ll take a closer look at some factors like financial leverage to see how sustainable TGP’s ROE is. Check out our latest analysis for 360 Capital Group
Breaking down ROE — the mother of all ratios
Return on Equity (ROE) is a measure of TGP’s profit relative to its shareholders’ equity. It essentially shows how much TGP can generate in earnings given the amount of equity it has raised. Generally speaking, a higher ROE is preferred; however, there are other factors we must also consider before making any conclusions.
Return on Equity = Net Profit ÷ Shareholders Equity
ROE is measured against cost of equity in order to determine the efficiency of TGP’s equity capital deployed. Its cost of equity is 8.55%. Given a positive discrepancy of 22.04% between return and cost, this indicates that TGP pays less for its capital than what it generates in return, which is a sign of capital efficiency. ROE can be split up into three useful ratios: net profit margin, asset turnover, and financial leverage. This is called the Dupont Formula:
Dupont Formula
ROE = profit margin × asset turnover × financial leverage
ROE = (annual net profit ÷ sales) × (sales ÷ assets) × (assets ÷ shareholders’ equity)
ROE = annual net profit ÷ shareholders’ equity
The first component is profit margin, which measures how much of sales is retained after the company pays for all its expenses. Asset turnover shows how much revenue TGP can generate with its current asset base. And finally, financial leverage is simply how much of assets are funded by equity, which exhibits how sustainable TGP’s capital structure is. Since ROE can be artificially increased through excessive borrowing, we should check TGP’s historic debt-to-equity ratio. Currently, TGP has no debt which means its returns are driven purely by equity capital. Therefore, the level of financial leverage has no impact on ROE, and the ratio is a representative measure of the efficiency of all its capital employed firm-wide.
What this means for you:
Are you a shareholder? TGP’s ROE is impressive relative to the industry average and also covers its cost of equity. Since ROE is not inflated by excessive debt, it might be a good time to add more of TGP to your portfolio if your personal research is confirming what the ROE is telling you. If you’re looking for new ideas for high-returning stocks, you should take a look at our free platform to see the list of stocks with Return on Equity over 20%.